Russia Hemorrhages at Least $211.5 Billion in Illicit Financial Outflows Over 18 Years

WASHINGTON, DC – The Russian economy hemorrhaged US$211.5 billion in illicit financial outflows from 1994—the earliest year for which data is available following the dissolution of the Soviet Union—through 2011, according to a new report released Wednesday by Global Financial Integrity (GFI), a Washington, DC-based research and advocacy organization. The study, titled “Russia: Illicit Financial Flows and the Role of the Underground Economy,” [HTML | PDF] also measures massive illicit inflows to the Russian economy of $552.9 billion over the 18-year time-span, raising serious questions about the economic and political stability of the nation currently chairing the G20.

“Russia has a severe problem with illegal flows of money,” said GFI Director Raymond Baker. “Hundreds of billions of dollars have been lost that could have been used to invest in Russian healthcare, education, and infrastructure. At the same time, more than a half trillion dollars has illegally flowed into the Russian underground economy, fueling crime and corruption.”

Underground Economy

GFI Lead Economist Dev Kar and GFI Economist Sarah Freitas, the authors of the study, estimate the size of Russia’s underground economy at a massive 46% of GDP per year over the time period. Moreover, illicit outflows and inflows were found to drive the domestic underground economy, which includes—among other things—drug smuggling, arms trafficking and human trafficking. Thus, illegal capital flight was determined to contribute to a deterioration in governance. Growth in the underground economy likewise was shown to drive illicit flows, creating “a snowballing effect, whereby both the underground economy and illicit flows continue to grow at an increasing rate unless policy measures and institutions intervene,” according to Dr. Kar, the principle author of the report, who worked as a senior economist at the International Monetary Fund before joining GFI.

A 1% increase in the size of the underground economy was found to increase the cross-border flow of illicit money by 7%.

The report reveals that, according to World Bank staff, Russia’s underground economy is 3.5 times larger than corresponding G-7 economies like the U.S., France, and Canada, and Russia lags far behind every G-7 country in all six dimensions of governance measured by the World Bank.

Further, illicit flows and the underground economy both grew significantly over the 18-year period studied, driven in large part by an overall deterioration in governance and widespread tax evasion.

The study highlights that in 3 out of the 6 key governance factors measured by the World Bank—voice and accountability, control of corruption, and regulatory quality—Russia’s standings have deteriorated since the fall of the Soviet Union, while remaining poor in the other categories—rule of law, government effectiveness, and political stability.

“So long as the Russian authorities fail to shrink the underground economy, Russia will continue to hemorrhage scare capital, both illicit and licit, to the detriment of economic and political stability and undermining the nation-state,” write Dr. Kar and Ms. Freitas in the 68-page report.

Unrecorded Wire Transfers

Unrecorded wire transfers detected by GFI’s Hot Money Narrow (HMN) model were the primary method for moving money illicitly out of Russia. HMN, which accounted for $135 billion or 63.8% of illicit outflows over the period studied, is one of two models used by GFI to estimate illicit financial flows—the other being the Gross Excluding Reversals (GER) model, which tracks trade-based money laundering through the fraudulent misinvoicing of customs declarations. Still, trade misinvoicing accounted for the remaining 36.2%, or $76.5 billion, of illicit outflows, and it is growing in significance.

The prevalence of unrecorded money transfers through banks is not surprising when considering the state of the Russian banking system. Citing research by the Financial Action Task Force, Dr. Kar and Ms. Freitas note serious weaknesses in Russian banks including that:

Some banks are still believed to be owned and controlled by criminals and their front men;

There is no requirement to investigate the background and purpose of suspicious transactions or to record and maintain such information for follow-up by regulatory agencies;

While credit institutions are prohibited from opening anonymous accounts, there is no specific provision that prohibits banks from maintaining existing accounts under fictitious names;

Gaps in monitoring wire transfers remain;

Sanctioning powers and the sanctions themselves are in general completely inadequate;

A key weakness is the lack of effectiveness of financial sector supervision regarding AML/CFT compliance; and

The existing AML/CFT regime and its implementation do not effectively deal with the illegal alternative remittance systems operating in Russia.

“There will continue to be massive illegal outflows of money through unrecorded wire transfers as Russia neglects to address these shortcomings in the banking system,” adds Dr. Kar.